Activity Based Costing

In recent years there has been criticism of the traditional system of costing for
overheads ( Kaplan & Cooper ). Traditional cost systems were designed when:

direct costs were the dominant factory costs;

overhead costs were relatively small;
information processing costs were high;
there was a lack of intense global competition;
a limited range of products was produced.

Traditional product costing measures accurately volume-related resources eg. direct

costs but they fail to measure the way products consume non-volume related
activities eg. support services like material handling, set-up costs, inspection costs.
Resources are used up when these activities are triggered by production. It is the
products which cause these activities to arise and ABC attempts to trace the
consumption of these activities by the various products. Products which demand a
lot of activities and resources are allocated an appropriate share of the overheads.
For example, a new product will probably be low volume initially, requiring a lot of
machine set-ups, quality testing etc. so it should bear the overheads it is causing to
be created.

Example: Two products A and B are produced ( 5000 units of A and 45000 units of
B). Each product requires the same number of machine/direct labour hours.
Number of set-ups: A = 10

B=5

The cost of set-ups is 1.2m.

Absorption costing:

Product A = 120,000 (10% of 1.2m.) / 5000units = 24 per unit

Product B = 1.08m (90% of 1.2m.) / 45,000 units = 24 per unit

ABC system:

Product A = 800,000 (10/15 x 1.2m) / 5,000 units = 160 per unit

Product B = 400,000 (5/15 x 1.2m) / 45,000 units = 8.89 per unit

Since product A, the low volume product is responsible for the greater share of the
set-up costs it is only right that it attracts most of this overhead. It is the number of
set-ups that is the cost driver. The traditional costing system tends to overcost high
volume products and undercost low-volume but complex products.

Definition: Activity based costing (ABC) is concerned with cost attribution to cost
units on the basis of benefit received from direct activities eg. ordering, set-up,
assuring quality.

ABC states that activities cause costs and products/cost units consume the
activities. It is used by management to determine the most profitable products and
to appreciate the cost implications of the operational activities within the business.
It gets management to understand what causes costs. The technique uses cost
drivers to attribute costs to activities and cost objects. Thus, overheads can be
related to the activities which cause them.

ABC divides activities into four categories:

Unit level activities which arise each time a product is manufactured eg.
machine power, depreciation of machinery etc.

Transaction level activities which arise each time a transaction happens eg.
quality control, inspection costs, set-up costs etc.

Plant level activities which relate to costs arising from the maintenance and
operation of the business facilities.

In absorption costing overheads are assigned to cost centres and charged to cost
units by usually a volume-based measure such as machine or labour hours whereas

ABC uses a two-fold approach by locating costs in cost pools and identifying cost
drivers to facilitate assigning costs to cost units.

In product costing it is relatively easy to charge direct costs to cost units but the
problem arises in relation to indirect costs(overheads). Overhead costs(resource
costs) such as rent, rates, maintenance costs, cleaning materials etc. which can be
identified with a particular cost pool are located there. Other overheads which
cannot be identified with a cost pool are apportioned to the cost pools by means of
cost drivers which are the main determinants of the cost of activities. These
overheads are pre-determined in that they are part of the budgeting process. These
cost drivers might include the number of production runs, the number of customer
orders received, the number of quality control tests, etc.

Activity cost pool

Activity cost driver

Advertising

The value of sales in each sales

area

Quality control

The number of quality tests

Purchasing

The number of purchase orders

Set-up costs

The number of set-ups/production

runs

Stores

The number of material requisitions

Despatch

The number of despatch notes

When the overheads are located in the cost pools an average cost per transaction is
calculated by dividing the total cost of an activity by the number of transactions
performed. This average cost is then used to to charge each product with the
amount of service demanded from each activity cost pool. Consequently, products
are charged with a fairer share of the overheads they have helped to create. The
result is more accurate product costing, better decision-making in respect to the
product output mix and product pricing.

Example:

The ABC company produces two products X and Y and the following information is
given:

Product X

Product Y

Total

25,000

5,000

30,000

--------

-------

--------

Direct labour

25

20

Direct materials

15

Machine hours

Labour rate per hour ()

Number of set-ups

20

Number of inspections

40

80

Production
(units)

and

Sales

Unit cost ()

Operating data

Overheads
Production processing

700,000

Set-up

120,000

Inspections

180,000

Required;

Calculate the product costs using (a) Absorption costing (b) ABC.

(a) Assuming the overheads are absorbed on the basis of direct labour hours.

Budgeted overheads

1,000,000

OAR =

---------------------------

-------------

Labour hours

= 2.50 per hour

400,000

All production overheads are located in one cost pool. The unit costs of products X
and Y are:

Direct labour

15.00

5.00

Direct materials

25.00

20.00

Overhead (2.50 per d.l.h.)

37.50

12.50

-------

--------

77.50

37.50

-------

-------

(b) In ABC three cost pools are identified viz. production processing, set-up and
inspection costs. The cost drivers are also identified eg.

Cost Driver

Basis

Production processing

Number of machine hours

Machine set-ups

Number of machine set-ups

Inspections

Number of inspections

The overheads per cost pool and the rate per cost driver are computed.

Production processing costs:

Production overhead
-----------------------------

700,000
=

------------

Machine hours

= 20 per mach.hr.

35,000

Set-up costs:

Cost per set-up

Set-up cost
----------------

120,000
= ------------

No. of set-ups

= 5,000 per set-up.

24

Inspection cost:

Cost per inspection Inspection cost

------------------- = 180,000 = 1,500 per
No. of inspections

The final stage of the process is to use the cost driver rates to assign overhead cost
to products.

Direct labour

15.00

5.00

Direct materials

25.00

20.00

Production
(1)

20.00

40.00

overhead

Set-up costs (2)

0.80

20.00

Inspection (3)

2.40

24.00

------

-------

63.20

109.00

-------

-------

X =20 x 1 machine hr. =20; Y = 20 x 2 machine hours = 40

X = (5,000 x 4 set-ups)/2,500 units = 80p; Y = (5,000 x 20 set-ups)/5,000

units = 20

X = (1,500 x 40 inspections)/ 25,000 units = 2.40; Y = (1,500 x 80

inspections)/ 5,000 units = 24

The comparison of the two approaches is given:

Product X

Product Y

Absorption costing

77.50

37.50

ABC

63.20

109.00